A working paper exploring the idea that information equilibrium is a general principle for understanding economics. [Here] is an overview.

Friday, January 23, 2015

I'm not sure economists understand supply and demand

I had put off watching the new Economics 101 videos from "Marginal Revolution University" until I had a sufficient contiguous chunk of time available. My reaction to the first video is pretty much summed up by this blog post titled Why people hate economics, in one lesson. And I have some philosophical objections to starting with the axiom that incentives matter -- at least as a useful methodology for producing tractable models.

The first few videos after the introduction look at supply and demand curves and then look at equilibrium. Now I am completely behind the idea of supply and demand curves and the equilibrium price. I actually derived them from information theory here. But the logic behind the supply and demand curves MR University show -- to be honest it's not really any different from how they were taught in my high school economics class, or how they are explained on Wikipedia -- is way too dependent on the specific relationships of a particular good (they use oil). More oil is produced at a higher price because it becomes profitable for companies to look for and extract harder to find and extract oil. But this isn't true for software (additional units are have almost zero cost, so it gets cheaper because upfront development costs become lower per unit). And the fact that the demand curve slopes down seems to be more a result of inequality for some goods (more people would buy iPads if they could afford them) than marginal utility. And in real life, people get upset at Uber or 'price gougers' who raise their price when supply is scarce. This makes it seem brutal.

Yes, yes: barriers to entry, patents and upfront capital costs. However, my point isn't that the supply and demand curves are wrong because specific examples are wrong or seem heartless. As I said in the previous paragraph, I believe in supply and demand. I have an issue because the way MR University teaches assumes the marginal utility interpretation of supply and demand -- that "incentives matter", and specifically pecuniary incentives. More oil is produced because it is profitable. I buy more of something because it was cheaper.

This becomes more apparent in the equilibrium price video (linked above) where Alex Tabarrok tells us about an experiment by Vernon Smith and concludes that the supply and demand model works. However, the Smith experiment assumes the utility version of the supply and demand model! He hands out pieces of paper with different utilities (measured in money [1]) and different marginal unit costs of production, forcing the structure of supply and demand curves given in the models. It is a bit like saying all two-player games result in ties, then designing tic tac toe and saying it proves your assertion.

It is not clear that the result of the Smith experiment is anything other than an asynchronous poll [2] of the price on the student's cards -- and that has nothing to do with supply and demand [4].

[2] Markets are really strange as polls or information aggregation devices. It essentially says that if you are good at predicting things in one domain (say, business), you should be rewarded with money and hence a greater ability to try and predict things in unrelated domains (say, politics). If you make a lot of money in sporting goods, you have been granted the means to try your hand at farming or producing records. I don't really take being good at one thing as evidence you are good at something else.

[3] In the information transfer model, you do have the freedom to make different sign choices; it basically says that a negative change in a quantity is keeping the two quantities (supply and demand) in information equilibrium instead of a positive change. You could look at this as measuring the price of land in terms of the quantity of land left. The ordinary supply and demand model doesn't really allow you the freedom to look at the problem in this alternate way.

[4] It is nagging at me why Tabarrok doesn't get this. It's not like he doesn't have a PhD in economics or anything. Am I missing something? Or is it just motivated reasoning (from me or Tabarrok)? Tabarrok makes a point of saying that Smith thought it wouldn't work. I have no idea why Smith would think it wouldn't work and that's not just the curse of knowledge. Even if the prices announced in the auction were random, the result would be the same equilibrium price. The only two kinds of equilibria I can think of are ones that on average have the equilibrium price given by the cards and the ones where the market doesn't clear (not all of the cards are traded) that should generally have an observed price below the equilibrium price (according to the information transfer model).